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QD View – Delhi’s dilemma – navigating the region’s geopolitics

Regular readers of our research and news may have noticed that, at QuotedData, we are quite positive on India as an investment destination. While acknowledging that, as a sprawling democracy of some 1.4bn people and the world’s fifth largest economy, India inevitably has its challenges. Nonetheless, there is much to recommend it.

In our view, India is one of the world’s largest and most dynamic emerging markets. It is a democracy that has benefitted from a stable and reform-focused government in recent years; has the advantage of a huge population that is growing and is also relatively youthful; has an expanding middle-class; has reformed and cleaned up the debt of its previously problematic banking sector; offers huge catch up potential in terms of GDP per capita; and, having taken the pain of enacting some key structural reforms in recent years, now benefits from a government that is prioritising growth over reform.

India’s economy is relatively domestically driven, but is definitely outward looking, seeking to grow both its exports and FDI. I was therefore somewhat surprised and disappointed to see its reluctance to denounce Russia’s invasion of Ukraine, particularly at the UN, as well as moves, including the purchase of lowly-priced oil in mid-March, that seemed to favour Russia and help it to try and navigate around sanctions that India’s Western allies have imposed. I was keen to understand the Indian government’s thinking, given the heat it has faced internationally from taking this stance.

Ocean Dial, a specialist asset manager focused on India, has recognised these issues, and has grasped the nettle of addressing them. On Wednesday, I joined a webinar that it hosted which included a panel of experts with a deep understanding of the geopolitical landscape that India is trying to navigate and the concerns that have driven its muted response to the developments in Ukraine. I would recommend that readers interested in the region watch the playback; I found it informative, and I think that it makes interesting viewing (click here to view).

A demographic dividend in a colossal market

Before diving into the geopolitics, I think it is worth fleshing out some thoughts on why investors might wish to have some exposure to India. An often-overlooked fact is that India has a huge population that is the world’s second largest after China (India accounts for around 18% of the people on the planet) but, unlike China, which is now bearing a heavy demographic cost from its now abandoned one child policy, India has a relatively youthful population and one that is growing. To put this in context, in 2020, 26.2% of the population was 14-years and under, while 44.2% of the population was under 25. At the other end of the scale, just 19.4% of the population was over 50 (all sourced from populationpyramid.net). Population growth has been edging down ever so slightly in recent years (from 1.10% in 2010 to 0.99% in 2020) but has consistently grown at around 1% per annum for the last decade.

According to data from the World Bank, India’s GDP per capita, based on purchasing power parity, is only 43% of that of China’s and 10% of that of the US, suggesting huge catch-up potential. India therefore has a vast, growing and relatively cheap labour force and, as noted above, has also benefitted from major structural reforms in recent years that have been designed to root out corruption, drive forward growth and make the country an attractive place to invest.

Reaping the benefits of reform

Since his election in May 2014, much of Prime Minister Narendra Modi’s time in power has been largely taken up with structural reforms of the economy. While both initially disruptive, India’s Goods and Services Tax and its Insolvency and Bankruptcy Code have now been in place long enough for their positive impacts to be seen, while the demonetisation programme and associated reforms have been very effective at weeding out corruption and bringing India’s black economy into the light. The benefits of this have been numerous. Many companies have passed through the country’s improved regulatory system and emerged from it better as a result, improving India’s credibility as an investment destination.

Sclerotic banking sector reformed

When we were first writing on India Capital Growth back in 2016 (click here to see all of our notes on the fund), we commented that the public sector banking system was plagued by non-performing loans (a hangover from the heady days of the credit boom) and that the government’s response to the problem had been inadequate, which was creating paralysis within the system. However, since the collapse of IL&FS in September 2018, which brought India’s banking sector to its knees, government policy has reformed the sector for the better. Key to this was the creation of a bad bank to deal with the debt mountain, which has cleaned up lenders’ balance sheets and brought much-needed fresh liquidity to the sector. Going forward, banks are much better capitalised, and India should no longer face the prospect of having to deal with both a liquidity squeeze and a banking crisis at the same time.

Infrastructure investment to drive future growth

Having driven through reforms to address corruption, India’s government has turned its attention to measures designed to support future growth. India’s infrastructure has been a significant impediment to its rate of development and the National Monetisation Pipeline unveiled by the finance minister in August last year is designed to bring in private capital to finance much needed improvements. Under the scheme, the government will lease out state-owned infrastructure assets – including roads, railways, airports and power plants – to private operators for a specified period. It will then reinvest the returns into new infrastructure projects under the previously announced National Infrastructure Pipeline. In addition to helping raise capital, it is believed that the programme could unlock efficiencies, particularly in areas of asset management and maintenance.

The elephant in the room (or the tiger at the border)

Tanvi Madan (a senior fellow in the Foreign Policy program at the Brookings Institution – where she specializes in Indian foreign policy) identified four key inter-linked developments that she believes are driving India’s current policy outlook. Not surprisingly, COVID and the US withdrawal from Afghanistan make this list, as does Russia’s invasion of Ukraine, but what may be less apparent to western viewers is the effect that the crisis at the border with China is having on the Indian government’s thinking.

The relationship between India and China is at its lowest ebb since the Sino-Indian war of 1962. Early last year it emerged that four Chinese soldiers and 20 Indian soldiers died in a clash at the disputed Himalayan border in June 2020 (neither side reportedly carried guns, but soldiers fell to their deaths as they fought with rocks). These were the first deaths for decades and the boundary crisis has continued.

The deaths and China’s actions have caused an inflexion point in India’s approach to China, which it considers has violated a long-established status-quo and various commitments. While India has seen China as a challenger since the 1950s, the conventional thinking was that India could compete with China and manage the risk. This approach dovetailed with its long-held policy of strategic independence or non-aligned foreign policy, which goes back to its own independence. However, the renewed conflict has changed India’s thinking dramatically, and it now sees China as a serious threat to its territorial integrity. India also worries that, with the world focused on events in Ukraine, Beijing will take advantage of the situation.

India continues to look towards the West

The good news is that, despite it being quiet when it comes to Russia, India is very much looking to its alliances with the West for the future. However, as discussed below, India is heavily dependent on Russia for its front-line defence equipment, as well as energy imports. Putin has made clear his intentions to cut off ‘unfriendly nations’ and India doesn’t want to risk putting itself in that camp. A further concern for New Delhi is the apparent deepening of ties between Moscow and Beijing. While the Indian government has tilted towards the west in condemning the atrocities in places such as Bucha, it is trying to balance its desire to align itself with the West, while simultaneously not giving China the upper hand by restricting its own ability to defend itself.

A surprising level of military dependence on Russia

While it is not easy to obtain figures, consensus opinion suggests that over 95% of India’s main battle tanks, almost all of its armoured vehicles, over 95% of its fighter aircraft, and around two-thirds of its anti-ship cruise missiles were acquired from Russia or the Soviet Union. While India has increasingly sought to manufacture defence equipment at home, this has often been done in collaboration with Russia and so its own security remains heavily tied into Russia’s own defence apparatus. With tensions high at more than one of its borders, India cannot afford to be cut off from new defence equipment or even spare parts.

Re-shoring and China plus one favour India

While the West may have hoped to see a clearer alignment with Ukraine than the regions geopolitics have allowed, it is clear that India remains a country that the West is happy to business with. China, on the other hand, has sullied its reputation with both its overly warm overtures to Moscow and the strict application of its zero-COVID policy. This has been to the detriment of Western supply chains that rely on its output. The last couple of years had already shown up the fragility of international supply chains and so the latest moves have added impetus shifting away from a ‘just-in-time’ approach to one of ‘just-in-case’.

Reflecting the push towards greater supply chain resilience, companies have looked to re-shoring to bring their supply chains closer to home, as well as diversifying their supply chains to reduce risk. This has led to an acceleration in the adoption of ‘China plus one’ strategies, of which India is well placed to benefit as a reliable low-cost manufacturing hub. For example, Apple has moved beyond China and is now building iPhone 13 at Foxconn’s plant in Sriperumbudur near Chennai. When developing their supply chains, Western multinationals tend to look for like-minded partners and India, with its democratic ideals, tends to fit the bill for many.

The RBI has flexibility to defend India’s currency

With the war in Ukraine exacerbating energy price rises and China’s zero-Covid policy disrupting supply chains and fuelling inflation as well, central banks across the globe have been raising interest rates in an attempt to cool economic growth and choke off inflation. The Fed (US central bank) funds rate now stands at between 0.75 and 1.0%, and committee members are suggesting that it could reach 2.5% by the end of 2022, with further rises expected in 2023. It is a realistic prospect that this tightening could overshoot with the possibility of a significant global recession next year. Rising interest rates in the US tend to be negative for Asia as they drive outflows of hot money, deflating these economies. India, however, has built up strong foreign exchange reserves and the Reserve Bank of India (RBI) has shown that it is willing to use these to defend the currency. When the Fed made its most recent 50bp increase, the RBI increased its base rate by 40 basis points (0.4%) in response. Despite this, there have been strong outflows but these have been readily replaced with local investment and both the Indian equity market and rupee have been relatively resilient.

Long-term structural growth story is intact

If rising interest rates do lead to a slowdown, as seems increasingly likely, India will suffer along with most developed and emerging economies but, being more domestically focused, should weather this better than the likes of China, Korea and Japan that are much more dependent on exports. Given India’s dependence on energy imports, the RBI is incentivised to protect the currency, but has plenty of reserves it can deploy to do this as well as stimulating the economy. This suggests any slow-down should be relatively short-lived.

Looking beyond the short-term noise, the long-term growth story remains intact and is bolstered by improving infrastructure and the reforms to the banking sector. India has done a lot of hard work to make itself an attractive investment destination and domestic investors have been readily taking up the slack. Now, it needs to complete the puzzle by getting out and promoting itself as a worthy long-term destination for FDI.

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